For millennials, it is absolutely necessary to get an early jump on retirement savings. Social Security collections can no longer be expected to be around by future generations, but thankfully, many of today's young people are well aware and planning around this.
While there are a dizzying number of retirement savings plans available in this day and age, two have established themselves as by far the most popular: the 401(k) and Roth IRA accounts. When planning for retirement as a millennial, however, many are asking themselves which is best for them.
Company-provided pension benefits are becoming a thing of the past.
As such, many employers offer a 401(k) plan for long-term employee savings in a tax-free environment. The 401(k) is an employer-sponsored program that allows members to defer the income taxes from chunks of each paycheck to a later date by putting that money in a sort of tax dead zone to be drawn upon at a later date. The benefit to this savings plan comes when an employer agrees to match a certain percentage of the employee's contribution, to be added directly into the 401(k) account.
If your employer is one of the many providers of 401(k)s, the program will operate like this:
- An employee signs up for the employer-provided 401(k) program.
- The employee chooses from a list of investments available within the program.
- The employee chooses how much of their paycheck they would like deferred to the 401(k) account tax-free until a later date. Note: In 2015, U.S. employees could allocate up to $18,000 of their yearly income into their 401(k) account (tax-free), according to Kiplinger,
With a 401(k), the contributor won't be able to withdraw his or her savings until the ripe old age of 59.5 years old, according to Forbes. If you end up needing your money sooner, you can take your money out, though not without being hit with a 10 percent penalty on the accumulated savings in addition to paying back all of the taxes on the previously earned income.
Typically, 401(k)s will work best for individuals whose employer is willing to match a large percentage of their savings. According to 401khelpcenter.com, the average company contribution to 401(k)s in America was 2.7 percent in 2015. So, if your employer agrees to match your savings up to 3 percent, it means that any amount you contribute at or below that level will be doubled by your employer. Some call this "free money."
The Roth IRA:
A Roth IRA is a special retirement account where the contributor pays taxes on money going into their account, but receives all future withdrawals tax-fee, according to RothIRA.com. Roth IRAs work in essentially the opposite way regarding taxability from 401(k)s:
The balance of 401(k) accounts is taxed when money is taken out of the account, which typically happens sometime during the account holder's 60s. A Roth IRA's balance is made up of pre-taxed income, meaning that taxes are taken out initially, before the the money even goes in. This can be extremely beneficial for millennials new to the workforce, as they typically won't be making much money, compared to later in their lives.
Roth IRAs are better for individuals who:
- Are able to begin saving early; and
- Expect lots of career growth and increasing income in years to come
"Roth IRAs work in essentially the opposite way regarding taxability from 401(k)s."
The key benefit Roth IRAs aim to exploit is the amount of taxes you pay on your income, versus how much interest that money ultimately earns. When you're young, you're probably earning less than you will when you are older and more established. When you're earning less, you pay fewer taxes on that income. Toward the end of your career, after you have climbed the ladder and are earning more, you will most likely belong to a higher tax bracket. Roth IRAs allow your life's income to be taxed as it comes, so you'll have less taken out for taxes in the grand scheme.
There is a cap on how much you can contribute to your Roth each year, set at $5,500 per year as of 2015, according to Investopedia. In addition, Roth IRAs provide tax-free contributions as well as tax-free withdrawals, though you can only withdraw without penalty after you turn 59.5. Withdrawals from your Roth before that time are slapped with a 10 percent penalty, according to the RothIRA.com. Any withdrawal after 59.5 years of age is penalty-free, though only if your Roth has been open for at least five years.
"If millennials can grasp and accept the idea of saving and investing early while delaying some things they want, but really don't need, they will have the ultimate experience when they reach their retirement years ... ," said certified financial planner and owner of Sheehan Life Planning Dan Sheehan, in a statement to Investopedia.
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